Multi-sector private credit strategies offer higher risk-adjusted returns. This reflects their illiquidity and complexity premium versus equivalent public bonds. And, by taking exposure through a diversified portfolio of mainly senior secured investments, we can seek to mitigate the severity of any losses.
Source: Aberdeen Standard Investments. Yield pick-up vs. similarly rated public corporate bonds. Yield pick-ups are indicative only. Gross of fees.
Source: The recovery rate for “public corporate debt” is based on BBB unsecured corporate debt and the recovery rate for “private corporate debt” is based on BBB senior secured loans. Both are sourced from Moody’s Annual Default Study: Corporate Default and Recovery Rates, 1920-2016. The recovery rate for “infrastructure debt” is sourced from Moody’s Default and Recovery Rates for Project Finance Bank Loans, 1983-2015. The recovery rate for “commercial real estate debt” is sourced from Cyclicality in Losses on Bank Loans by Bart Keijsersy, Bart Diris and Erik Kole. The recovery rate for “corporate loans” is sourced from S&P Credit Analytics: Credit Pro Loss Stats database, 1987–2016. Statistics based on ultimate recovery rates.
Ability to originate transactions is key
Private debt is not widely offered to credit investors. So the ability to originate transactions is a crucial part of the multi-sector private credit strategy, allowing the manager to capture the best available opportunities. The challenge is to create a diversified portfolio over time – especially as visibility on the pipeline of transactions can vary across asset classes. For example, infrastructure debt transactions often take many months to complete, while private placement for corporates can be executed in just two weeks.
Institutional investors continue to see a decent flow of opportunities. One factor behind this is that the banks are deleveraging and so are less willing to lend. In addition, the low-yield environment and Solvency II capital requirements have incentivised insurance firms to increase exposure to private credit. Private credit offers predictable and stable cash flows that match their liabilities, with the potential for higher long-term returns.
A robust governance and operational platform are vital for private credit investments to be scaleable. From a strategy prospective, a private-credit house-view covering trends, fundamentals, technical analysis and valuation on each asset class can help portfolio managers implement the investment strategy with optimum efficiency.
Asset allocation to private credit
With the wide range of opportunities across the rating and duration spectrums, multi-sector private credit strategies can be tailored to suit a client’s risk appetite and return expectations.
For example, the strategy may be relatively defensive, with opportunities across high-rated public sectors (local authorities, social housing, universities). These typically offer very long maturities (over 20 years) and bullet repayment. Or the strategy may move down the credit rating spectrum to capture more attractive returns.
To successfully allocate to private credit requires experienced sector specialists, and cashflow modelling and structuring. While bottom-up credit selection is crucial, overall portfolio risk can be adjusted by careful assessment of macro and geopolitical drivers. This allows investors to outperform across different market environments and deliver consistent returns. Investing in shorter-maturity bonds and amortising bonds is a good way for investors to adjust sector allocation (tactical asset allocation), as the loan matures and the market environment is evolving. In addition, investments with positive social and environment impact continue to garner attention. Social housing and renewable energy are likely to remain a major consideration for insurance and pension fund asset allocators.
One important benefit of a multi-sector strategy is the low correlation to the global economy and other asset classes. There is limited data on the performance of such a strategy post-Covid. Nevertheless, it seems reasonable to expect investment-grade strategies to show greater resilience to the Covid crisis, given that a large swathe of the universe is linked either to public policy or regulatory risk.
Illiquidity premiums have widened somewhat recently, particularly for private placements and commercial real estate debt transactions. However, we see a wide range of opportunities in terms of credit quality. For example, the effect of Covid on real estate debt transactions differs dramatically from one opportunity to another. While high-street retail and shopping centres remain out of favour, there is growing competition for properties with stronger fundamentals. These include supermarkets, warehouses, industrials and certain retail parks.
Non- Investment Grade strategies which usually include leverage loans continue to attract investors given they are typically secured by first-lien charges and therefore offer stronger recovery prospects. Indeed, while the leverage loans market experienced high volatility in the first lockdown (although less than the High-Yield bonds market), actual European loan defaults remain muted.
Across asset-backed securities, collateral performance is expected to marginally deteriorate, but from a very low base. So, the outlook remains stable overall, given the credit enhancement and excess spread.
Infrastructure debt remains reasonably resilient. However, extra vigilance is needed for assets exposed to power prices (renewables), demand (student accommodation), economic growth (toll roads, airports) or construction. Construction projects for example suffered delays but these are generally mitigated by ‘float’ in build programmes and/or builders taking the financial risk. There is an increasing focus on green infrastructure. This could lead to the risk of spread compression and/or a shift to lower-credit quality. For instance, it may encourage lending to less established sectors such as subsidy-free renewables and more complex technologies (such as. battery storage).
Private credit strategy, post-Covid
The Covid outbreak has required lenders to be more flexible in their approach with borrowers. Unsurprisingly, increasing numbers of covenants are being amended and restructured.
One sector which has been seriously affected by the Covid crisis is transportation. Investors are right to remain cautious in the near term given the restrictions on air travel. Nevertheless, with spreads repriced at much wider levels, loans to, for example airport and train operators could generate significant longer-term opportunities. This ‘Covid premium’ can offer an extra yield for those investors able to discern potentially rewarding transactions for the long run.
Yet, despite soaring infection rates and new lockdowns in Europe, the public credit market remains strong. This is driven primarily by supportive central bank action – specifically bond-buying programmes. This has caused yields on public bonds to fall and spreads to tighten. Conversely, the illiquidity premium for private credit transactions has widened, with investors fearful about the longer-term effects of the pandemic.
Summary
As in previous crises, the Covid pandemic is a timely reminder for investors to remain selective in the way they deploy their capital, maintaining a well-diversified portfolio with asset classes which have low or negative correlations. A multi-sector approach can be an effective way to seek sustainable returns across the different economic cycles.
